The Setup

Who Should Run It

When to Run It

You're bullish. You may also be anticipating neutral activity if strike B is out-of-the-money.

The Sweet Spot

You want the stock to be at or above strike B at expiration, so both options will expire worthless.

About the Security

Options are contracts which control underlying assets, oftentimes stock. It is possible to buy (own or long) or sell (“write” or short) an option to initiate a position. Options are traded through a broker, like TradeKing, who charges a commission when buying or selling option contracts.

Options: The Basics is a great place to start when learning about options. Before trading options carefully consider your objectives, the risks, transaction costs and fees.

The Strategy

A short put spread obligates you to buy the stock at strike price B if the option is assigned but gives you the right to sell stock at strike price A.

A short put spread is an alternative to the short put. In addition to selling a put with strike B, you’re buying the cheaper put with strike A to limit your risk if the stock goes down. But there’s a tradeoff — buying the put also reduces the net credit received when running the strategy.

Maximum Potential Profit

Potential profit is limited to the net credit you receive when you set up the strategy.

Maximum Potential Loss

Risk is limited to the difference between strike A and strike B, minus the net credit received.

Break-even at Expiration

Strike B minus the net credit received when selling the spread.

TradeKing Margin Requirements

Margin requirement is the difference between the strike prices.

NOTE: The net credit received when establishing the short put spread may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold (good) but it will also erode the value of the option you bought (bad).

Implied Volatility

If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.

If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).

Options Guy's Tips

One advantage of this strategy is that you want both options to expire worthless. If that happens, you won’t have to pay any commissions to get out of your position.

You may wish to consider ensuring that strike B is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the further out-of-the-money the strike price is, the lower the net credit received will be from this spread.

As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.

Tools

Options Scanner
Scan a universe of over 150,000 option contracts to help find your potential trade.

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Multiple-leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult your tax adviser. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct.

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